Euro at risk if countries fail to play game of carrot and stick

More bad news for Christian Noyer, the governor of the French central bank
who's been fuming over Britain's AAA credit status.

Noyer translates into English as the verb to drown or sink, which is exactly what's happening to his country's credit rating and the prospects for saving his beloved euro. As a noun his name also translates as a type of nut – walnut to be precise – but we'll leave that for another day.Photo: Bloomberg

Noyer translates into English as the verb to drown or sink, which is exactly what's happening to his country's credit rating and the prospects for saving his beloved euro. As a noun his name also translates as a type of nut – walnut to be precise – but we'll leave that for another day.

Anyway, after another miserable seven days for the eurozone it's clear last week's Brussels summit did nothing to solve the immediate debt crisis facing the Club Med countries. Nor did it do anything to stem the tide of contagion flowing from toxic sovereign debt in the south to banks in the north which has dragged France and Germany further into the mire.

Credit-rating agencies remain nervous of eurozone banks, governments (yes, that means France, M. Noyer) and the new institutions being created to try to battle the great funding crisis engulfing Europe.

The cost of fire-fighting the eurozone's debt crisis is "staggering" according to none other than Klaus Regling, the head of the European Financial Stability Fund (EFSF), the eurozone's main bail-out vehicle. On Friday he estimated more than €1 trillion (£840bn) had already been spent trying to solve the debt crisis. Another €100bn may be needed for a second Greek bond buying spree while he promised there was €600bn still available to come to the aid of Italy and Spain if needed.

All this resource is simply trying to plug a hole, a black hole some would say, which has opened up in the heart of the eurozone's creaking financial system.

Fitch became the latest rating agency to cast doubt on the euro project on Friday evening, highlighting the "absence of a credible financial backstop" for the currency system and calling for a more active and explicit commitment from the European Central Bank (ECB).

However, Berlin-centric institutions such as the ECB are not about to open up a credit sluice for the benefit of Greece, Italy, Spain or any other less than AAA-rated country.

Instead what we are witnessing with these interminable summits, arguments and frustrations is a Continental game of carrot and stick, both being wielded ultimately by Germany, with the stick very much coming first.

Without reform of deficit countries' fiscal policies, without deep austerity measures and subjugation of national budgets to the European Court of Justice there will be no carrot.

In the short term the carrot would be funding for government debt through bodies such as the International Monetary Fund and the EFSF and support for banks through the ECB. The carrot element has so far proved controversial, and not forthcoming, with the Germans apparently opposed to such financial salve.

But as Nicolas Doisy, an economist at Cheuvreux, part of Credit Agricole, pointed out in a note on Friday, this is also a game of chicken. Angela Merkel wants to see real reform and contrition among the likes of Greece and Italy for their previous debt addiction before she will permit the money to flow. The agony of the crisis reveals just how far she is pushing this process. Who will chicken out first? The offenders, it would seem.

On Friday Mario Monti, Italy's technocrat prime minister, took a significant step forward in making sure the fiscal stick was applied to the backs of Italians by winning a vote in parliament forcing through an emergency €30bn series of budget cuts.

But such measures will surely exacerbate recession in Europe, not help it. True. The stick cannot be applied without causing recession, at least short term, and the UK will be affected.

But the depth of the downturn next year will be dictated in part by further stimulus which Europe's institutions could deliver if reforms are meaningful and permanent (which the new eurozone treaty is designed to ensure).

Remember July and a previous summit-to-end-all-summits when Europe's leaders declared a "Marshall Plan" would be mobilised to help Greece and others return to growth?

Talk of America's 1948-52 financial aid package for a war-ravaged Europe came with too many military associations and was changed to a task force but even so, that piece of the puzzle has understandably been overlooked in recently as the crisis has escalated.

But there is no doubt in the minds of German politicians that money for specific infrastructure investments and other worthy growth-boosting expenditure would be forthcoming if other countries were truly sorry and changed they way they behave. And therein lies the biggest problem for this carrot and stick game because it takes two to play. The Italians, Greeks Portuguese and others may simply refuse to take part.

That's called democracy, even though it might mean the end of the euro.